July 10, 2012

1:55 pm

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Ask any entrepreneur about what they’re building and the problems they are solving, and their eyes light up. But ask any entrepreneur about their financial model, and the energy disappears.

Trust me, I talk to entrepreneurs every day as a venture capitalist, and I’ve been helping entrepreneurs build financial models for over 10 years, and I’ve seen the reaction thousands of times. But building financial models can still be valuable, if you remember one thing: the model doesn’t matter, the thought process does. Overly complex financial models are a waste of time without a solid understanding of the basic inputs and outputs of your business. That’s why I’ve worked to help entrepreneurs think about finance and build financial models the right way.

In March 2012, I ran a survey to understand what entrepreneurs thought about financial models, and found 4 key insights.

1. Financial models are largely BS

The recurring response I heard from entrepreneurs was that financial models are useless at best, and potentially even worse:

“A financial model is just a fancy equation with a bunch of input variables. If the input variables are mistaken, it doesn’t matter how good the equation is, the whole thing is useless – or even worse than useless, as it breeds false confidence.”

True, to a degree. If your inputs are mistaken or a poor approximation of reality, then the results (revenue, net income) will be highly inaccurate. But the results aren’t the important parts to a financial model. Nobody cares about your hockey-stick growth projections, but people do care about how you think you’re going to create that hockey-stick growth. The results don’t matter, but the thought process is critically important. Instead of worrying about building accurate financial projections, spend your energy building a model that helps you tell the story behind your business:

“In the end, the most important thing isn’t a really detailed financial model – it’s having a grasp of what the major influencing factors are on your model (hint: sales and growth) and then getting some kind of data that helps you accurately predict these variables.”

2. How do I get good data for my assumptions?

Over half of respondents noted the difficulty in finding good data to ground their assumptions, and this is something that comes up with every entrepreneur I talk to. How much should I charge? How many people will buy it? How long will someone remain a customer? What will my conversion rate be? How many times will they use it? What will my viral coefficient be?

And answering these questions isn’t easy, especially in light of the prevailing view that financial models are useless without good inputs.

There’s a couple keys to getting good data for one’s assumptions:

Research. Ask potential customers. Ask other entrepreneurs for their experiences. Research comparable companies. And test assumptions by putting the product in market and learning from actual users and customers.

Create scenarios. Acknowledge the fact that there are a variety of potential outcomes for each one of your key inputs and use range estimates to create scenarios. Instead of making point estimates (e.g., the conversion rate will be 5%), use range estimates (the conversion rate should be between 2% and 10%) to create best, worst, and expected scenarios using single- and multi-variate analysis.

Accept that good data for your assumptions is hard. Instead of focusing on getting the best possible data about your assumptions, get a solid understanding of the potential ranges and create a financial model that allows you to understand how your business model flexes.

3. There aren’t enough resources, templates, and guidance on how to get started

Many entrepreneurs had no idea where to start, and struggled to create financial models themselves. Templates and best practices are hard to find on the web, so entrepreneurs typically end up figuring it out for themselves, asking other entrepreneurs for examples, or asking investment bankers or MBAs to help them build their financial models.

But there are problems with each route. Many first-time financial modelers build manual, hard-coded models that are difficult to change and alter, and often difficult for others to understand. Experienced entrepreneurs can be great resources, but their models will likely differ from your own business idea, and thus you will need to do extensive customization anyway. And while investment bankers and MBAs typically have extensive experience in building financial models, it’s usually not the right type of experience for building financial projections for startups, as they tend to be overly complicated, top-down models that tell little about the real business model of the startup.

The best route? Look at examples, ask other entrepreneurs, and build a model yourself until you reach a point where you need more help. Where is that point?

4. Don’t build the best financial model possible. Only build what you need for that point in time, and iterate your model in parallel with your business

Not only do entrepreneurs have difficulty in starting to build financial models, they often have problems figuring how much of a model to build. Do I need to build five-year projections? Do I need detailed cost structure? Do I need full financial statements? Do I need a complete capitalization table and valuation estimates?

Taking an insight from the Lean Startup movement, the key is to build a “minimum viable model.” Focus on building a model that will help you make the key decisions you have to make at that point in time, and communicate the current story behind your business. For some, that “minimum viable model” may be a simple cost budget, and a basic understanding that there is a large customer base with a willingness to pay for your product. For some, it may be a robust projections of costs and revenues. For some, it may require complete financial statements and projections with a detailed capitalization table.

But the important thing is to spend one’s energy appropriately. Yes, financial models are always wrong. Yes, build products and demos before spreadsheets. But spreadsheets can still play an important role in understanding and building your business if you approach them correctly.

Guest author Taylor Davidson (@tdavidson) is an early-stage venture capitalist at kbs+p Ventures and a mentor to a range of early-stage ventures. Over 6,000 entrepreneurs have downloaded one of his financial models for startups. Tech Cocktail has partnered with Davidson to offer this important tool on an ongoing basis (look in the right rail under Sponsors and Partners).

Act fast! The first 100 Tech Cocktailers to download either one of the models using code “TechCocktail” will get 25% off.